Asset Allocation: How To Diversify For Maximum Return
Table of Contents
Contrary to popular belief, asset allocation, which refers to the types or classes of securities owned, is generally the most important factor in determining the return on your investments, responsible for about 90 percent of the return according to experts. The remaining 10 percent of the return is determined by which particular investments (stock, bond, mutual fund, etc.) you select and when you decide to buy them.
What is not so important is what's referred to as "market timing."
Likewise, buying a "hot" stock or mutual fund recommended by a financial magazine or newsletter, a brokerage firm or mutual fund family, an advertisement or any other source is generally not a good move.
Market timing refers to the concept of moving in and out of an investment or an investment class in anticipation of a rise or fall in the market; however, it's been proven over and over again that the modern market cannot be timed. In other words, market timing is a strategy that just does not work.
Asset allocation, on the other hand, is the cornerstone of good investing. Each investment made is part of an overall asset allocation plan. Further, this plan must not be generic (one-size-fits-all), but rather must be tailored to your specific needs.
Sound financial advice from a trusted and competent advisor is very important as the investment world is populated by many "advisors" who either are unqualified or don't have your best interests at heart.
That said, here are the basic investment guidelines you should live by:
These concepts are discussed further in the following sections.
Asset allocation is based on the proven theory that the type or class of security you own is much more important than the particular security itself. Asset allocation is a way to control risk in your portfolio. The risk is controlled because the six or seven asset classes in the well-balanced portfolio will react differently to changes in market conditions such as inflation, rising or falling interest rates, market sectors coming into or falling out of favor, a recession, etc.
Asset allocation should not be confused with simple diversification. Suppose you diversify by owning 100 or even 1,000 different stocks. You really haven't done anything to control risk in your portfolio if those 1,000 stocks all come from only one or two different asset classes--say, blue chip stocks (which usually fall into the category known as large-capitalization, or large-cap, stocks) and mid-cap stocks. Those classes will often react to market conditions in a similar way they will generally all either go up or down after a given market event. This is known as "correlation."
Similarly, many investors make the mistake of building a portfolio of various top-performing growth funds, perhaps thinking that even if one goes down, one or two others will continue to perform well. The problem here is that growth funds are highly correlated-they tend to move in the same direction in response to a given market force. Thus, whether you own two or 20 growth funds, they will tend to react in the same way.
Not only does it lower risk, but asset allocation maximizes returns over a period of time. This is because the proper blend of six or seven asset classes will allow you to benefit from the returns in all of those classes.
Asset allocation planning can range from the relatively simple to the complex. It can range from generic recommendations that have no relevance to your specific needs (dangerous) to recommendations based on sophisticated computer programs (very reliable although far from perfect). Between these extremes, it can include recommendations based only on your time horizon (still risky) or on your time horizon adjusted for your risk tolerance (less risky) or any combination of factors.
Computerized asset allocations are based on a questionnaire you fill out. Your answers provide the information the computer needs to become familiar with your unique circumstances. From the questionnaire will be determined:
The goal of the computer analysis is to determine the best blend of asset classes, in the right percentages, that will match your particular financial profile.
At this point, the "efficient frontier" concept comes into play. It may sound complex, but it is a key to investment success.
The securities that exist in today's financial markets can be divided into four main classes: stocks, bonds, cash, and foreign holdings, with the first two representing the major part of most portfolios. These categories can be further subdivided by "style." Let's take a look at these classes in the context of mutual fund investments:
Equity Funds: The style of an equity fund is a combination of both (1) the fund's particular investment methodology (growth-oriented, value-oriented or a blend of the two) and (2) the size of the companies in which it invests (large, medium and small). Combining these two variables - investment methodology and company size - offers a broad view of a fund's holdings and risk level. Thus, for equity funds, there are nine possible style combinations, ranging from large capitalization/value for the safest funds to small capitalization/growth for the riskiest.
Fixed Income Funds: The style of a domestic or international fixed-income fund is to focus on the two pillars of fixed-income performance - interest-rate sensitivity (based on maturity) and credit quality. Thus, fixed-income funds are split into three maturity groups (short-term, intermediate-term, and long-term) and three credit-quality groups (high, medium and low). These groupings display a portfolio's effective maturity and credit quality to provide an overall representation of the fund's risk, given the length and quality of bonds in its portfolio.
Simply stated, financial advisors build asset allocation models by (1) taking historic market data on classes of securities, individual securities, interest rates, and various market conditions; (2) applying projections of future economic conditions and other relevant factors; (3) analyzing, comparing and weighting the data with computer programs; and (4) further analyzing the data to create model portfolios.
There are three key areas that determine investment performance for each asset class:
It's important to be informed about asset allocation so as to avoid the "cookie cutter" approach that many investors end up accepting. Many of the asset allocations performed today take this "one size fits all" approach.
There are all sorts of investment recommendations, but the question is whether they are suitable for you. Regardless of the approach you take, be sure that an asset allocation takes into account your financial profile to the extent feasible.
The "efficient frontier" concept is a key to investment success. A graph demonstrating the efficient frontier is shown below.
Any expected return (left side of graph) carries with it an expected risk (bottom of graph). This risk-reward relationship varies from individual to individual. Conservative investors cannot tolerate more than a low level of risk, and are willing to accept a return commensurate with that level of risk. More aggressive investors are willing to tolerate higher levels of risk in the expectation of higher returns.
The efficient frontier is a line on the graph that represents a series of optimal risk-return relationships. That is, every dot on the line represents the highest return for a given level of risk or, stated conversely, the lowest risk for a given rate of return. Conservative investors will aim for a spot on the left side of the efficient (low return, low risk) while aggressive investors will aim for the right side (high return, high risk). If your portfolio (present or proposed) falls on the efficient frontier line, it has an optimal risk-return relationship, but nonetheless still may not be suitable for you because it may be too aggressive or too conservative. Your portfolio should be at that spot on the efficient frontier that approximates your particular risk-return goal.
As shown on the graph, if you are willing to tolerate an expected risk (standard deviation) of, say, 12, then you can reasonably (not definitely) expect an approximate return of 10 percent over a period of time (Portfolio C) - if your portfolio is efficient.
It is unlikely, over time, that returns will be higher than those shown on the efficient frontier. Of course, you may, in specific instances, achieve a higher return than that shown, but your average return over time will generally not exceed the amount shown.
If your portfolio falls below the efficient frontier, then it is "inefficient" in that it exposes you to too much risk for the specified return or, conversely, provides too low a return for the specified risk. Unfortunately for investors, most portfolios fall substantially below the efficient frontier.
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